While the overall outlook for the space remains favorable, a number of issues remain. The biggest headwind undoubtedly is the Fed uncertainty, with many in the market now expecting the central bank to announce the next rate hike at the December meeting. The modest upturn in long-term treasury yields in recent days is a reflection of this development, which is not favorable for rate-sensitive sectors like REITs (utilities and telecoms are some of the other spaces).

In addition to the interest rates issue, REITs’ performance can be dulled by the weakness in the underlying asset categories. In fact, if close heed is not paid to all the weakness before investing in REIT stocks, one can end up incurring big losses.

Fundamental Weakness

Of late, things turned worse for residential REITs as increased supply in many of the markets sounded alarms. In fact, markets with high rents like San Francisco, New York and San Jose have been much affected and the high end and luxury apartment categories have been flooded with new supply. Usually, higher supply curtails landlords’ ability to demand higher rents and leads to lesser absorption. Also, job losses in the energy sector are weighing on the Houston market.

Reflecting such weaknesses, in Q3, the average effective rent nationwide grew 3% year over year, per an Axiometrics study. This not only marked a decrease from the solid 5.2% rent growth experienced one year ago, but also denoted the fourth straight quarter in which the annual rent-growth rate declined. Also, there seems to be no respite from the situation anytime soon and the moderation is anticipated to continue next year with a whole lot of new construction slated to be delivered.

Further, though upbeat consumer confidence and an improving economy have infused optimism into the retail market, mall traffic continues to suffer amid a rapid shift in customers’ shopping preferences and patterns with online purchases growing by leaps and bounds. These have made retailers reconsider their footprint and eventually opt for store closures.

Also, retailers that are not being able to cope with competition are filing bankruptcies. This has emerged as a pressing concern for retail REITs, as the trend is curtailing demand for the retail real estate space considerably.

In the self-storage industry, rising supply in some of the markets is affecting revenue growth. On the other hand, per a CBRE Group Inc. study, the industrial market is on its lengthiest stretch of recovery, with availability rates declining for the 25^th straight quarter to 8.8% in Q2, the lowest since mid-2001. So, chances of any striking decline in availability rates are less. Also, a whole lot of new construction is expected over the next two years, which can put a pause on growth next year.

When Rates Finally Move Up

REITs have breathed a sigh relief with the Fed deciding to keep the rate unchanged in its last meeting. However, the eventual rise in interest rates will no doubt be a burden on debt-dependent REITs. Moreover, the dividend payout itself might turn out less attractive than the yields on fixed income and money market accounts.

Also, this could impact healthcare REITs. This is because these REITs usually have significant exposure to long-term leased assets which carry fixed rental rates that are subject to annual bumps. Therefore, as rate goes up, the cost of borrowing will increase but their revenue flows will not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Further, volatility in rates can further cast a pall on mortgage REITs or mREITs, which offer real estate financing through the purchase or origination of mortgages and mortgage-backed securities. These REITs fund their investments with equity and debt capital and earn profits from the spread between interest income on the mortgage assets and their funding costs. Though these types of REITs have started adjusting their strategies and business models, they bear long-term risk as interest rates will eventually rise.

Bottom Line

Therefore, before calling the shots for investments, investors should satisfy themselves by dispassionately absorbing both sides of the argument and then call the shots.

Check out our latest REIT Industry Outlook here for more on the current state of affairs in this market from an earnings perspective.

REITs to Avoid

Specific REITs that we don't like include Five Oaks Investment Corp. , The GEO Group, Inc. (GEO Quick QuoteGEO - Free Report) , Public Storage (PSA Quick QuotePSA - Free Report) and Select Income REIT .

Five Oaks Investment Corp. is a mREIT and presently has a Zacks Rank #5 (Strong Sell). Its full year 2016 and 2017 estimates have experienced a southward revision over the past two months.

The GEO Group, a prison REIT, has a Zacks Rank #5. Its estimates for full year 2016 and 2017 have witnessed negative revisions over the past two months as use of private detention facilities by the Bureau of Prison and Immigration and Customs Enforcement is questioned.

Public Storage, a self-storage REIT, presently has a Zacks Rank #4 (Sell). The company came up with lower-than-expected performances in the prior two quarters. Also, its estimates for 2016 and 2017 have experienced downward revisions over the past two months.

Select Income REIT, which is engaged in primarily owning and investing in net leased, single tenant properties, has a Zacks Rank #4. Its long term growth rate of 5.3% is below the industry average of 7.2%. Select Income REIT also witnessed negative revision to its 2016 and 2017 estimates over the past three months.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

 

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